1. School of Business and Economics Studium Generale The euro area sovereign debt crisis: causes and consequences Prof. Dr. Olaf Sleijpen Maastricht, 3 November 2011

2. School of Business and Economics Agenda 1)A short (conceptual) history of European monetary integration 2)Fiscal discipline in the Treaty 3)Evidence of fiscal discipline in the euro area 4)Lessons to be drawn: the inconsistent triangle revisited 5)A new perspective on nominal and real convergence in the euro area 6)An assessment of the euro area summit of 23 October 7)Concluding remarks

3. School of Business and Economics A short (conceptual) history of European monetary integration Economic and Monetary Union Maastricht Treaty Convergence approach “Big Bang” approach -Inspired by Optimal Currency Area theory -Full nominal and real convergence required -Appropriate adjustment mechanisms in place in case of (asymmetric) shocks -Monetary union is the “crown” on convergence process -Convergence will follow automatically after Start monetary union -Discipline imposed by fixed exchange rates will trigger nominal and real economic discipline -Nominal convergence required; No real convergence -Strongly embedded monetary policy structure in place -Intergovernmental framework to impose fiscal discipline; no framework to impose real convergence

4. School of Business and Economics Why fiscal discipline matters in a monetary union Preventing spillovers from fiscal to monetary policy Preventing spillovers from national fiscal policies to other Member States Absorption of asymmetric shocks at the national level Market discipline flawed Macro-economic and financial stability

5. School of Business and Economics Fiscal discipline in the Maastricht Treaty Multilateral surveillance procedure Excessive deficit procedure Prohibition of priviliged access No bail-out clause

6. School of Business and Economics The Stability and Growth Pact Revisited Adopted in 1997 (Amsterdam European Council) Reform in 2004 Preventive arm –Strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies Corrective arm –Speeding up and clarifying the implementation of the excessive deficit procedure

7. School of Business and Economics 98 99 00 01 02 0304 05 07 06 08 09 Source: European Commission, Spring Forecasts 2010 and budgetary plans according to national budgets. Insufficient compliance … % GDP

8. School of Business and Economics Budget deficit % of GDP …became apparent during the crisis Source: European Commission, Spring Forecasts, 2010.

9. School of Business and Economics Increase in debt… Gross public debt euro area % of GDP Source: European Commission, Spring Forecasts 2010.

10. School of Business and Economics …and late market reaction Source: Thomson Financial. Interest rate spread with German government debt (10-year maturity) % points

11. School of Business and Economics Consequence: financial stability risk in EMU Source: Eurostat and CBS (for The Netherlands). DEFRITESNLGRPTIE 199833.850.926.924.219.529.337.9na 200442.746.038.647.352.953.456.458.7 200849.655.642.345.965.5na77.172.7 Government debt held by non-residents (% of total)

12. School of Business and Economics The (new) inconsistent triangle The inconsistent triangle (Padoa-Schioppa, 1985) –Incompatibility between fixed but adjustable exchange rates, full capital mobility and independent monetary policies –This inconsistent triangle prooved to be true in the EMS Crisis (1992-1993) The new inconsistent triangle –Incompatibility between single monetary policy, full capital mobility and independent fiscal policies –Reflected by the current crisis in the euro area

13. School of Business and Economics What doe this inconsistent triangle imply? Fiscal consolidation is necessary, but will take time –And will not reassure financial markets in the short term If the (new) inconsistent triangle is true, a major overhaul of the institutional set-up of the euro area is necessary A major reform of the institutional set-up may not sooth financial markets –Enlarged and flexible EFSF as temporary solution

14. School of Business and Economics Strengthening economic governance – the view of the EU Towards greater fiscal discipline Broadening economic surveillance: a new surveillance mechanism Deeper and broader coordination: the “ European Semester ” Robust framework for crisis management Stronger institutions for more effective economic governance

15. School of Business and Economics The importance of enhancing national fiscal rules and frameworks Relationship between plausibility of projections stability programmes and national fiscal rules, after taking into account other explanatory variables. Source: Beetsma, Giuliodori and Wierts (2009, Economic Policy)

16. School of Business and Economics Short-term government debt outstanding (central government) Source: Hoogduin, Öztürk and Wierts (2010). More focus on debt financing

17. School of Business and Economics An assessment of the economic (fiscal) governance Excessive deficit and follow-up should be called by Community institution –Framework should become less intergovernmental Sanctions should be efficient and effective –Value-added of fines, etc. is limited Financial support limited to strong conditionality

18. School of Business and Economics Economic convergence revisited Nominal convergence (interest rate, inflation, public finance) Real convergence  (labour) market flexibility  (assymetric) shock absorption by national budgets (automatic stabilisers)

19. School of Business and Economics Inflation euro area: low and stable… Source: Thomson Financial. Inflation euro area % changes (y-o-y)

20. School of Business and Economics …but inflation differentials persistent Source: Thomson Financial. Inflation (HICP) % changes (y-o-y)

21. School of Business and Economics Current account balance % euro area or world GDP Imbalances have increased Source: IMF.

22. School of Business and Economics % GDP and % changes Causes imbalances Source: European Commission.

23. School of Business and Economics Average deterioration of the budgetary position Budget periphery more affected After crisis (Spring 2010) Before crisis (Autumn 2007) Before crisis (Autumn 2007) After crisis (Spring 2010) A. Other EMU countries B. Portugal, Ireland, Italy, Greece and Spain Source: European Commission, Economic forecasts.

24. School of Business and Economics Crisis reveals relationship imbalances and budgetary position Before crisis (Autumn 2007)After crisis (Spring 2010) R 2 = 0,6034 R 2 = 0,1647 Source: European Commission, Economic forecasts.

25. School of Business and Economics What has been agreed on 23 October? European Council Banking package Euro Summit Sustainable public finances and structural reform Refining the Greek programme –Monitoring –PSI and credit enhancement EFSF –Leverage resources of the EFSF Economic governance

26. School of Business and Economics Assessment of the 23 October package Pro’s Increase in “fire power” of the EFSF Package necessary to sooth markets Further enhancement of economic governance Con’s PSI not clear Leverage: will it work? Enhanced economic convergence: not enough? Implementation lag

27. School of Business and Economics Concluding remarks Financial crisis has revealed weak compliance with and enforcement of fiscal and economic policy rules in EMU Insufficient fiscal discipline; insufficient real convergence “Every cloud has a silver lining”: broadening and deepening of policy framework necessary –But more ambition necessary